Facebook and WhatsApp: A Deal Too Far?

I’m on vacation in Mexico this week, with limited Internet access, but here are a few immediate thoughts on Facebook’s acquisition of WhatsApp, a messaging start-up. I won’t pretend to be an expert on WhatsApp, or on what distinguishes its technology from that of other similar services. But, from a financial perspective, the obvious thing that stands out is the price that Facebook is paying: up to nineteen billion dollars.

Even in Silicon Valley, that’s a great deal of money to pay for a company with virtually no revenues, but it doesn’t prove positively that Mark Zuckerberg and Sheryl Sandberg are overpaying. When they bought Instagram for a billion dollars, in 2012, many people thought it was a crazy price. Now, that purchase is widely regarded as a bargain.

Is this a bigger version of the Instagram acquisition, or is it a deal too far? Until I get a chance to examine it more closely, I’m reserving judgement. But a few things strike me immediately:

First, Facebook was reportedly facing competition from Google, and that may well have driven up the price considerably. According to the Wall Street Journal, Morgan Stanley represented WhatsApp. If the investment bank didn’t extract the last dollar possible from Facebook, it wasn’t doing its job. As every economist knows, auctions of this sort often work out badly for the winner. (Hence the term “the winner’s curse.”)

Second, it’s largely a stock deal. According to the Times, the owners of WhatsApp will receive four billion dollars in cash and twelve billion dollars’ worth of Facebook stock. (WhatsApp employees and founders get another three billion dollars in restricted stock units, vesting over the next four years.) Why does the form of payment matter? Because you can’t make sense of this deal, or others like it, without considering it.

If the owners of WhatsApp had demanded an all-cash payment, it’s highly doubtful that Facebook would have agreed to pay up to nineteen billion dollars. But Facebook has an extremely highly valued currency—its own stock—that it can use in acquisitions. As I pointed out in a post about Internet stocks a couple of weeks ago, Facebook isn’t the most overpriced one around, but it’s still some wonderful wampum; in the past eight months, it has tripled in value, and by the close of business on Wednesday, it was trading at a hundred and eleven times earnings and forty-one times its cash flow. (For comparison purposes, Apple trades at thirteen times its earnings and eight times its cash flow.)

For a company that is valued at roughly a hundred and seventy billion dollars, as Facebook was on Wednesday, issuing fifteen billion dollars in stock doesn’t seem like such a big step to take. In fact, the logic may go the other way: Why wouldn’t you do such a deal?

After all, with such a highly priced stock, Facebook faces enormous pressure to justify its valuation. In the tech industry, that means exhibiting very rapid growth rates and being perceived as the company of the future. In terms of new users, however, the growth rate of Facebook’s core social network is slowing down. With user-growth decelerating, the option of using company stock to purchase growth can be irresistible, especially when its the expansion of the sort exhibited by WhatsApp: from zero users to four hundred and fifty million in less than five years.

But the very thing that makes such a deal appealing also makes it risky. If the market perceives that Facebook was desperate to make the acquisition because its own business is coming close to exhausting its potential, the consequences for its stock could be serious. Investors didn’t mind Google blowing twelve and a half billion dollars on Motorola, in 2011, because they knew that the search giant’s core business was secure. Facebook’s business model is also based on advertising, but it hasn’t been around as long as Google’s, and some see it as less robust.

Again, this doesn’t prove that the purchase is a mistake—or that we are witnessing a bubble—but it does show that it’s a risky move for Facebook. Until recently, it was a social-networking giant, and that was that: everybody knew what it was. Now it appears to be morphing into a holding company for various Internet plays that are growing fast but that don’t have much revenues and don’t necessarily fit together. Almost a decade ago, eBay tried a similar strategy, when it bought Skype, a company that in some ways resembles WhatsApp. It didn’t work out; eBay eventually sold Skype to concentrate on its core business.